The digital revolution is bringing sweeping change to labour markets in both rich and poor worlds

Oct 4th 2014

TECHNOLOGICAL revolutions are best appreciated from a distance. The great inventions of the 19th century, from electric power to the internal-combustion engine, transformed the human condition. Yet for workers who lived through the upheaval, the experience of industrialisation was harsh: full of hard toil in crowded, disease-ridden cities.

The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income.

Computers that can do your job and eat your lunch

So far, the upheaval has been felt most by low- and mid-skilled workers in rich countries. The incomes of the highly educated—those with the skills to complement computers—have soared, while pay for others lower down the skill ladder has been squeezed. In half of all OECD countries real median wages have stagnated since 2000. Countries where employment is growing at a decent clip, such as Germany or Britain, are among those where wages have been squeezed most.In the coming years the disruption will be felt by more people in more places, for three reasons. First, the rise of machine intelligence means more workers will see their jobs threatened. The effects will be felt further up the skill ladder, as auditors, radiologists and researchers of all sorts begin competing with machines. Technology will enable some doctors or professors to be much more productive, leaving others redundant.

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Second, wealth creation in the digital era has so far generated little employment. Entrepreneurs can turn their ideas into firms with huge valuations and hardly any staff. Oculus VR, a maker of virtual-reality headsets with 75 employees, was bought by Facebook earlier this year for $2 billion. With fewer than 50,000 workers each, the giants of the modern tech economy such as Google and Facebook are a small fraction of the size of the 20th century’s industrial behemoths.Third, these shifts are now evident in emerging economies. Foxconn, long the symbol of China’s manufacturing economy, at one point employed 1.5m workers to assemble electronics for Western markets. Now, as the costs of labour rise and those of automated manufacturing fall, Foxconn is swapping workers for robots. China’s future is more Alibaba than assembly line: the e-commerce company that recently made a spectacular debut on the New York Stock Exchange employs only 20,000 people.The digital transformation seems to be undermining poor countries’ traditional route to catch-up growth. Moving the barely literate masses from fields to factories has become harder. If India, for instance, were to follow China’s development path, it would need skilled engineers and managers to build factories to employ millions of manufacturing workers. But, thanks to technological change, its educated elite is now earning high salaries selling IT services to foreigners. The digital revolution has made an industrial one uneconomic.

Bridging the gap

None of this means that the digital revolution is bad for humanity. Far from it. This newspaper believes firmly that technology is, by and large, an engine of progress. IT has transformed the lives of billions for the better, often in ways that standard income measures do not capture. Communication, knowledge and entertainment have become all but free. Few workers would want to go back to a world without the internet, the smartphone or Facebook, even for a pay increase. Technology also offers new ways to earn a living. Etsy, an online marketplace for arts and crafts, enables hobbyists to sell their wares around the world. Uber, the company that is disrupting the taxi business, allows tens of thousands of drivers to work as and when they want.Nonetheless, the growing wedge between a skilled elite and ordinary workers is worrying. Angry voters whose wages are stagnant will seek scapegoats: witness the rise of xenophobia and protectionism in the rich world. In poor countries dashed expectations and armies of underemployed people are a recipe for extremism and unrest. Governments across the globe therefore have a huge interest in helping remove the obstacles that keep workers from wealth.The answer is not regulation or a larger state. High minimum wages will simply accelerate the replacement of workers by machines. Punitive tax rates will deter entrepreneurship and scare off the skilled on whom prosperity in the digital era depends. The best thing governments can do is to raise the productivity and employability of less-skilled workers. That means getting rid of daft rules that discourage hiring, like protections which make it difficult to sack poor performers. It means better housing policy and more investment in transport, to help people work in productive cities such as London and Mumbai. It means revamping education. Not every worker can or should complete an advanced degree, but too many people in poor countries still cannot read and too many in rich ones fail to complete secondary school. In future, education should not be just for the young: adults will need lifetime learning if they are to keep up with technological change.Yet although governments can mitigate the problem, they cannot solve it. As technology progresses and disrupts more jobs, more workers will be employable only at lower wages. The modest earnings of the generation that technology leaves behind will need to be topped up with tax credits or wage subsidies. That need not mean imposing higher tax rates on the affluent, but it does mean closing the loopholes and cutting the giveaways from which they benefit.In the 19th century, it took the best part of 100 years for governments to make the investment in education that enabled workers to benefit from the industrial revolution. The digital revolution demands a similarly bold, but swifter, response.

“The information contained in earnings, balance sheets and economic releases is only a fraction of what is known by others. The action of prices and trading volume reveals other important information that traders are willing to back with real money. This is why trend uniformity is so crucial to our Market Climate approach. Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one. Valuations, trend uniformity, and yield pressures are now uniformly unfavorable, and the market faces extreme risk in this environment.”

“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week's decline was the decisive negative shift in these measures. Since early October of last year, I have at least generally been able to say in these weekly comments that ‘market action is favorable on the basis of price trends and other market internals.’ Now, it also happens that once the market reaches overvalued, overbought and overbullish conditions, stocks have historically lagged Treasury bills, on average, even when those internals have been positive (a fact which kept us hedged). Still, the favorable market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end. Evidently, it just ended, and the reversal is broad-based.”

“The worst market return/risk profiles we estimate are associated with an early deterioration in market internals following severely overvalued, overbought, overbullish conditions. This is what we observe at present. In contrast, the strongest market return/risk profiles we estimate are associated with a material retreat in valuations coupled with early improvement in market internals. I have every expectation that we will observe this combination over the completion of the present market cycle. So I expect that, perhaps to the surprise of many who don’t understand this approach, we will be quite bullish and aggressively invested as market conditions shift over the completion of the present market cycle. But now is emphatically not that time.”

The most hostile subset of market conditions we identify couples overvalued, overbought, overbullish extremes with a breakdown in market action: deterioration of breadth, leadership and other market internals, along with a shift toward greater dispersion and weakening price cointegration across individual stocks, sectors and security types (what we sometimes call “trend uniformity”). The outcomes are particularly negative, on average, when that shift is joined by a widening of credit spreads. That’s a shift we observed in October 2000. It’s a shift we observed in July 2007. It’s a shift that we observe today.

Remember that severe market losses are not by their nature broadly announced by obvious catalysts. As I noted approaching the 2007 peak: “Once certain extremes are clear in the data, the main cause of a market plunge is usually the inevitability of a market plunge. That's the reason we sometimes have to maintain defensive positions in the face of seemingly good short-term market behavior.” Asking what particular news event will trigger a market loss “is like having an open can of gasoline next to your fireplace and blaming the particular spark that sets it off. We need not investigate the personality, life history or future career path of that particular spark.”

Present market conditions comprise an environment where risk-premiums are thin and are being pressed higher. See Low and Expanding Risk Premiums are the Root of Abrupt Market Losses for more on why this matters. The current shift does not ensure that the market will decline over the short-term, nor that it will crash in this instance. It’s also worth noting that we don’t rely on a crash, and that we can certainly allow for the possibility that valuations and market internals will improve in a way that reduces or relieves our concerns without severe market losses.

Still, what we are concerned about here and now is the steeply negative average behavior of the market in historical periods that match present conditions, as well as the decided skew of that probability distribution, which features extreme negative observations far more often than would be expected under a “normal” bell-shaped distribution. Interestingly, the 3-day average implied skew embedded in S&P 500 index option prices surged last week to the highest level on record. The potential for a “fat-tail” event should be taken seriously here.

Why take the concerns of a “permabear” seriously?

The inclination to ignore these concerns is understandable based on the fact that I’ve proved fallible in the half-cycle advance since 2009. That’s fine – my objective isn’t to convert anyone to our own investment discipline or encourage them to abandon their own. Somebody will have to hold equities through the completion of this cycle, and it’s best to include those who have thoughtfully chosen to accept the historical risks of a passive investment strategy, and those who have at least evaluated our concerns and dismissed them. The reality is that my reputation as a “permabear” is entirely an artifact of two specific elements since the 2009 low, but that miscasting may not become completely clear until we observe a material retreat in valuations coupled with an early improvement in market internals.

For those who understand and appreciate our work, I discuss these two elements frequently because a) I think it’s important to be open about those challenges and to detail how we’ve addressed them, and b) it’s becoming urgent to clarify why we view present conditions as extraordinarily hostile, and to distinguish these conditions from others that – despite an increasingly overvalued market – our current methods would have embraced or at least tolerated more than we demonstrated in real-time.

For us, the half-cycle since 2009 has involved the resolution of two challenges.

The first: despite anticipating the 2007-2009 collapse, the timing of my decision to stress-test our methods against Depression-era data – and to make our methods robust to those outcomes – could hardly have been worse. In the interim of that “two data sets” uncertainty, we missed what in hindsight was the best opportunity in this cycle to respond to a material retreat in valuations coupled with early improvement in market internals (a constructive opportunity that we eagerly embraced in prior market cycles, and attempted to embrace in late-2008 after a 40% market plunge).

The second: I underestimated the extent to which yield-seeking speculation in response to quantitative easing would so persistently defer a key historical regularity: that extreme overvalued, overbought, overbullish market conditions typically end with tragic market losses. Those extremes have now been stretched, uncorrected, for the longest span in history, including the late-1990’s bubble advance. My impression is that the completion of the present market cycle will only be worse as a result.

The ensemble approach we introduced in 2010 resolved our “two-data sets” challenge, and was more effective in classifying market return/risk profiles than the methods that gave us a nice reputation by 2009, but our value-conscious focus gave us a tendency to exit overvalued bubble periods too early.

During the late-1990’s, observing that stock prices were persistently advancing despite historically overvalued conditions, we introduced a set of “overlays” that restricted our defensive response to overvalued conditions, provided that certain observable supports were present. These generally related to an aspect of market action that I called trend uniformity. In the speculative advance of recent years, we ultimately re-introduced variants of those overlays to our present ensemble approach.

As I observed in June, the adaptations we’ve made in recent years have addressed both of these challenges. See the section “Lessons from the Recent Half-Cycle” in Formula for Market Extremes to understand the nature of these adaptations. When we examine the cumulative progress of the stock market in periods we classify as having flat or negative return/risk profiles (and that also survive the overlays), the chart looks like the bumpy downward slope of a mountain. Present conditions are worse, because they feature both a negative estimated return/risk profile and negative trend uniformity on our measures. The cumulative progress of the stock market under these conditions – representing less than 5% of history – looks like the stairway to hell, and captures periods of negative market returns even during the bull market period since 2009. The chart below shows cumulative S&P 500 total returns (log scale) restricted to this subset of history. The flat sideways sections are periods where other return/risk classifications were in effect than what we observe today.

Though we’ve validated our present methods of classifying market return/risk profiles in both post-war and Depression-era data, in “holdout” validation data, and even in data since 2009, there’s no assurance they’ll be effective in the current or future instances. As value-conscious, historically-informed investors, we remain convinced that the lessons of history are still relevant. Our efforts have centered on embodying those lessons in our discipline.

While all of these considerations are incorporated into our approach, we’ve had little opportunity to demonstrate the impact we expect over the course of the market cycle. Applied to a century of historical market evidence, including data from the present market cycle, we’re convinced that the adaptations we’ve made have addressed what we needed to address.

Our concerns at present mirror those that we expressed at the 2000 and 2007 peaks, as we again observe an overvalued, overbought, overbullish extreme that is now coupled with a clear deterioration in market internals, a widening of credit spreads, and a breakdown in our measures of trend uniformity. These negative conditions survive every restriction that we’ve implemented in recent years that might have reduced our defensiveness at various points in this cycle.

My sense is that a great many speculators are simultaneously imagining some clear exit signal, or the ability to act on some “tight stop” now that the primary psychological driver of speculation – Federal Reserve expansion of quantitative easing – is coming to a close. Recall 1929, 1937, 1973, 1987, 2001, and 2008. History teaches that the market doesn’t offer executable opportunities for an entire speculative crowd to exit with paper profits intact. Hence what we call the Exit Rule for Bubbles: you only get out if you panic before everyone else does.

Meanwhile, with European Central Bank assets no greater than they were in 2008, and more fiscally stable European countries quite unwilling to finance the deficits of unstable ones, the ECB has far more barriers to sustained large-scale action than Draghi’s words reveal. Moreover, to the extent that the ECB intends to buy asset-backed securities (ABS), which have a relatively small market in Europe, the primary effect (much like the mortgage bubble in the U.S.) will be to encourage the creation of very complex, financially engineered, and ultimately really junky ABS securities that can be foisted on the public balance sheet. Watch. In any event, even if such monetary interventions continue indefinitely, I have no doubt that we’ll have the opportunity to respond more constructively at points where we don’t observe upward pressure on risk-premiums and extensive deterioration in market internals.

I should be clear that market peaks often go through several months of top formation, so the near-term remains uncertain. Still, it has become urgent for investors to carefully examine all risk exposures. When extreme valuations on historically reliable measures, lopsided bullishness, and compressed risk premiums are joined by deteriorating market internals, widening credit spreads, and a breakdown in trend uniformity, it’s advisable to make certain that the long position you have is the long position you want over the remainder of the market cycle. As conditions stand, we currently observe the ingredients of a market crash.

Another in what seems to be a small parade of scandals involving secretly recorded tapes of Federal Reserve regulators emerged last week. What a number of writers (including me) have written about regulatory capture over the past decade was brought out into the open, at least for a while. My brilliant young friend (40 seems young to me now) Justin Fox, editorial director of the Harvard Business Review and business and economic columnist for Time magazine, published a thoughtful essay this week, outlining some of the issues surrounding the whole concept of banking regulations.

Yes, the latest scandal involved Goldman Sachs, and it took place in the US, but do you really think it’s much different in Europe or Japan? Actually, there are those who argue that it’s worse in those places. This does not bode well for what happens during the next crisis (and there is always a next crisis, hopefully far in the future, though they do seem to come more frequently lately).

Writes Justin:

The point here is that if bank regulators are captives who identify with the interests of the banks they regulate, it is partly by design. This is especially true of the Federal Reserve System, which was created by Congress in 1913 more as a friend to and creature of the banks than as a watchdog. Two-thirds of the board that governs the New York Fed is chosen by local bankers. And while amendments to the Federal Reserve Act in 1933 shifted the balance of power in the Federal Reserve System from the regional Federal Reserve Banks (and the New York Fed in particular) to the political appointees on the Board of Governors in Washington, bank regulation continues to reside at the regional banks. Which means that the bank regulators’ bosses report to a board chosen by … the banks.

I’m in Washington DC today at a conference sponsored by an association of endowments and foundations. They have a rather impressive roster of speakers, so I have found myself attending more sessions than I normally do at conferences. Martin Wolf and David Petraeus headline a very thoughtful group of managers and economists, accompanied by an assortment of geopolitical wizards. I’ve learned a lot.

No follow-on note today. I need to get back to my classroom education…

Your loving the fall weather analyst,

John Mauldin, Editor
Outside the Box

Why the Fed Is So Wimpy

Regulatory capture – when regulators come to act mainly in the interest of the industries they regulate – is a phenomenon that economists, political scientists, and legal scholars have been writing about for decades. Bank regulators in particular have been depicted as captives for years, and have even taken to describing themselves as such.

Actually witnessing capture in the wild is different, though, and the newThis American Lifeepisode with secret recordings of bank examiners at the Federal Reserve Bank of New York going about their jobs is going to focus a lot more attention on the phenomenon. It’s really well done, and you should listen to it, read the transcript, and/or read the story by ProPublica reporter Jake Bernstein.

Still, there is some context that’s inevitably missing, and as a former banking-regulation reporter for the American Banker, I feel called to fill some of it in. Much of it has to do with the structure of bank regulation in the U.S., which actually seems designed to encourage capture. But to start, there are a couple of revelations about Goldman Sachs in the story that are treated as smoking guns. One seems to have fired a blank, while the other may be even more explosive than it’s made out to be.

In the first, Carmen Segarra, the former Fed bank examiner who made the tapes, tells of a Goldman Sachs executive saying in a meeting that “once clients were wealthy enough, certain consumer laws didn’t apply to them.” Far from being a shocking admission, this is actually a pretty fair summary of American securities law. According to the Securities and Exchange Commission’s “accredited investor” guidelines, an individual with a net worth of more than $1 million or an income of more than $200,000 is exempt from many of the investor-protection rules that apply to people with less money. That’s why rich people can invest in hedge funds while, for the most part, regular folks can’t. Maybe there were some incriminating details behind the Goldman executive’s statement that alarmed Segarra and were left out of the story, but on the face of it there’s nothing to see here.

The other smoking gun is that Segarra pushed for a tough Fed line on Goldman’s lack of a substantive conflict of interest policy, and was rebuffed by her boss. This is a big deal, and for much more than the legal/compliance reasons discussed in the piece. That’s because, for the past two decades or so, not having a substantive conflict of interest policy has been Goldman’s business model. Representing both sides in mergers, betting alongside and against clients, and exploiting its informational edge wherever possible is simply how the firm makes its money. Forcing it to sharply reduce these conflicts would be potentially devastating.

Maybe, as a matter of policy, the United States government should ban such behavior. But asking bank examiners at the New York Fed to take an action on their own that might torpedo a leading bank’s profits is an awfully tall order. The regulators at the Fed and their counterparts at the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation correctly see their main job as ensuring the safety and soundness of the banking system. Over the decades, consumer protections and other rules have been added to their purview, but safety and soundness have remained paramount. Profitable banks are generally safer and sounder than unprofitable ones. So bank regulators are understandably wary of doing anything that might cut into profits.

The point here is that if bank regulators are captives who identify with the interests of the banks they regulate, it is partly by design. This is especially true of the Federal Reserve System, which was created by Congress in 1913 more as a friend to and creature of the banks than as a watchdog. Two-thirds of the board that governs the New York Fed is chosen by local bankers.

And while amendments to the Federal Reserve Act in 1933 shifted the balance of power in the Federal Reserve System from the regional Federal Reserve Banks (and the New York Fed in particular) to the political appointees on the Board of Governors in Washington, bank regulation continues to reside at the regional banks. Which means that the bank regulators’ bosses report to a board chosen by … the banks.

Then there’s the fact that Goldman Sachs is a relative newcomer to Federal Reserve supervision – it and rival Morgan Stanley only agreed to become bank holding companies, giving them access to New York Fed loans, at the height of the financial crisis in 2008. While it’s a little hard to imagine Goldman choosing now to rejoin the ranks of mere securities firms, and even harder to see how it could leap to a different banking regulator, it is possible that some Fed examiners are afraid of scaring it away.

All this is meant not to excuse the extreme timidity apparent in the Fed tapes, but to explain why it’s been so hard for the New York Fed to adopt the more aggressive, questioning approach urged by Columbia Business School Professor David Beim in a formerly confidential internal Fed report that This American Life and ProPublica give a lot of play to. Bank regulation springs from much different roots than, say, environmental regulation.

So what is to be done? A lot of the classic regulatory capture literature tends toward the conclusion that we should just give up – shut down the regulators and allow competitive forces to work their magic. That means letting businesses fail. But with banks more than other businesses, failures tend to be contagious. It was to counteract this risk of systemic failure that Congress created the Fed and other bank regulators in the first place, and even if you think that was a big mistake, they’re really not going away.

More recently, there’s been a concerted effort to take a more nuanced view of regulatory capture and how to counteract it. The recent Tobin Project book, Preventing Regulatory Capture: Special Interest Influence and How to Limit It, sums up much of this thinking. While I’ve read parts of it before, I only downloaded the full book an hour ago, so I’m not going to pretend to be able to sum it up here. But here’s a thought – maybe if banking laws and regulations were simpler and more straightforward, the bank examiners at the Fed and elsewhere wouldn’t so often be in the position of making judgment calls that favor the banks they oversee. Then again, the p eople who write banking laws and regulations are not exactly immune from capture themselves. This won’t be an easy thing to fix.

As close fans of the monthly jobs report know, the unemployment rate can decline for two different reasons, broadly speaking: Either unemployed people find jobs and employment rises, or unemployed people give up entirely on the labor force and thus are excluded from the calculation.The first change — people finding jobs — is typically good news, while the second — people dropping out — is typically bad. Today’s report was more good news than bad news, with a 232,000 person gain in employment and a 97,000 person decline in the labor force. (Note that there are two different employment surveys — one of households, one of establishments — that tell slightly different stories. The numbers in this post come from the household survey, which is used to calculate the unemployment rate.)

“The drop was mostly for the right reasons,” said Michelle Girard, an economist at RBS Securities in a note. “But the magnitude of the move continues to be exaggerated by the underperformance of the labor force.”The economy has been plagued by a declining labor force in recent years. While part of this is due to the fact that the massive baby boom generation is reaching retirement age, the decline also includes people who have become too discouraged by the weak labor market to continue hunting for jobs. If the labor market were strong enough, some economists believe that many of these dropouts would return to the job market.Therefore, the best monthly jobs reports are those in which the labor force rises and employment rises by even more. The worst are those in which the labor force falls, and employment falls even more.Today’s report still had labor force dropouts. But mostly, it had job gains.

Central Banks around the world have given investors the illusion that all is well.

Just because gold has fallen in price from its highs the past 3 years doesn't mean that it's in a bear market. While you have read in many of my articles about the possibility of what a stronger dollar might do to gold I have also provided you with many of the indicators I follow so you can see the same things I see. But don't think for a moment any bearishness you may perceive I have has me negative on the future of gold. Don't believe for a moment that gold is in a bear market.

3 Phases of a Gold Bull Market

Richard Russell from Dow Theory Letters sums up best the 3 stages of a gold bull market (this quote was included in my book Buy Gold and Silver Safely).

First phase is where sophisticated investors, sensing a new bull market, make their initial commitment.

In the second phase, the public will start to buy gold, this in reaction to increasing political and social uncertainty, rising debt levels and nervousness as to the future of the dollar.

The third phase of the gold bull market will see a frantic rush by the public to buy gold. In this phase, gold will surge to undreamed of heights-a level beyond what anyone now envisions.

We are still in the second and longest stage of the gold bull market. It is during this stage where market makers will try and buck you off the gold bull. Just like with any stock, market makers will drive the price down and then drive the price up. They sometimes do this in quick moves on thinly-traded stocks and over a longer time frame with larger cap stocks. Many times it has nothing to do with valuation or news. It's simply how a market maker makes money.Their goal is to squeeze an investor out of a position. If it is a market moving higher, then they will try and squeeze the shorts out of their position and get them to cover their shorts driving the price even higher still. All the while, they are shorting the stock as it forms the candlestick tail signifying a top is in place. Then they reverse the process and trap the longs who got into the game late by driving the price down. If you don't understand that market makers do this for a living, then you haven't traded stocks very long.It is much easier for a market maker to move a stock that is thinly traded. If a stock has low volume, then you can see moves on a short-term basis that can knock someone out of their long or short position depending on which way the market makers wants to move the stock.While market makers actions are only part of the movement of gold and silver, they are an important part that can't be discounted.

Silver Price ActionThe Hunt Brothers in the late 70s took a thinly-traded silver market and cornered it by buying up all the physical silver they could while playing the futures market. The price of silver shot up to its all-time high of $50 an ounce and then proceeded to collapse after the Hunt brothers got into some trouble for their actions.Seeing what a blow off top looks like with a chart using candlesticks, look no further than the 2011 price action in silver in the chart below. See the tail on the long candle stick shooting upwards? Then see the subsequent price action? What I am looking for is the opposite of this to signify the silver bottom. This doesn't mean it will come before I write my "all in" article, but it is definitely one thing I would love to see.

(click to enlarge)Silver Chart 2011 Top

Deflation Everywhere, However, Debt Levels are Rising Everywhere

The news out of Europe is showing the smell of deflation has taken over everywhere. According to the Wall Street Journal, article, the annual rate of inflation in the Eurozone has fallen to a five-year low. This has caused the dollar to move strongly up versus the Euro surpassing the 86 mark as you can see in the chart below.UK housing fell for the first time in 16 months. Are things going to start imploding in the UK? Have you seen their debt to GDP ratio? How about that of Europe, Japan and the U.S.? Have any of these countries done anything to curb government spending?

Debt Levels Major Countries

Emerging Market Debt Levels Rising

Debt Levels Emerging Economies

Is this debt situation all of these countries are facing sustainable or unsustainable?

Central Bank Illusions

What should be noted here is that Central Banks around the world have given investors the illusion that all is well with their countries' economies because they have a technology called a printing press that can make up for the fact that money velocity has come to a standstill while deflation wreaks havoc on their inflationary efforts. They are funding government and helping out the banks with the assumption that the economy will pick up steam.This model has indeed worked for quite some time and many in the world have benefited from it. But it is governments who also abuse the system and the Central Banks are there to fund their madness. Both Congress and the Fed are at fault here in the U.S. and our national debt here that is fast approaching $18 trillion is indeed unsustainable once interest rates tick up.What if the central banks are wrong about an economic upturn? What if the Fed tapered too much too early? Does anyone even think the Fed can do wrong? Can I remind you that the 2008 crisis was caused by the Fed artificially lowering interest rates (among other issues like subprime lending and the unregulated derivatives fiasco) and the Fed AFTER THE FACT with Congress had to put $9 trillion into the economy to save it? Do we forget so easily because the financial media has you believing the Fed, Greenspan, Bernanke and now Yellen are our heroes? Well, they are the banks' heroes, and some well-connected investment firms among others.Below is your friendly reminder of what a mess the Fed got us into in 2008. How will they hold their credibility when the next crisis occurs? What are the odds of this occurring (see debt situation above)? What will the price of gold do?

2008 Crisis $9 Trillion Fed

Dollar Still King

While I have been dollar bullish for the short term, it doesn't mean that I am going to always be dollar bullish. As I have explained before, looking at the value of one currency priced in another is simply an illusion when all currencies buy you less and less over time. But perception at present is the U.S. Dollar is king while Europe and Japan go through their various issues. This is quite a two-day move for the dollar putting more pressure on gold and silver here in the U.S.

Dollar Index Over 86

The Gold Bull Market

In my last Current Thoughts on Gold and Silver section of my website I wrote the following about gold and silver.

Gold fell today after an early session higher but has not fallen below the closing low of $1,213.50 set a week ago. It still seems to me that it wants to break that 2013 low in the $1,190s. We simply aren't that far away from it and if we do break it, it could set up for a further decline in both gold and silver.

We did break below last week's price and it seems the break of the 2013 low is on the table. Keep in mind that this price is also resistance and we may get a short-term bounce. This would only be short lived as I am sticking with my call for a break of the lows. That's what market makers love to do. Make you scream. If you look at the historical chart for gold below the trend is still up. We are simply in the second and longest stage and you'll need a little patience for this stage to end and the third euphoria stage to begin. This might be just under $1,000 an ounce. That's the number I am targeting. Not what gold bulls want to hear. And if I was a market maker I'd want to bring gold down below $850 an ounce. But I would make for an awful mean market maker. Even if we hit those levels I would still be as bullish as one can be. It's because I can do simple math.

(click to enlarge)Gold Historical Chart

Current Advice on Buying Gold

My advice is still the same and that is to dollar cost average into the overall allocation you want to invest into precious metals. No one knows if I'll be right on the timing of my "all in" article, so I try and give you the best advice I can explaining what I see so you can time the markets the best that you can.For those that are looking for a way to trade the markets from a micro to intermediate level I highly recommend following Avi Gilbert's team at ElliotWaveTrader.net.I do believe it is better to own physical gold and silver and the good news is that unlike last year with the price drops, the premiums have not started to move higher yet with these price declines. For those that trade in and out of the gold markets or who don't mind the fees associated with an ETF and the fact you can't take physical possession of the metals (unless a large investor), then owning (NYSEARCA:GLD) or (NYSEARCA:SLV) might be an option. Other ways to invest in gold and silver would be through Eric Sprott's gold and silver trusts (NYSEARCA:PHYS) and (NYSEARCA:PSLV).

As I mentioned over the weekend, the month of September ended with two dramatically different exits: The Hollywood ending of Yankee Captain Derek Jeter's Hall of Fame 20-year career, and the acrimonious departure of Bill Gross from PIMCO, the firm he founded 43 years ago.The departure of the two could not have been in starker contrast. More importantly, as investors, we can learn a great deal by taking a moment to explore why Gross took the extraordinary step of leaving the institution with which he is synonymous.

It's About Gross' Investment Legacy, Not His Management Style

Derek Jeter is a rare breed in today's world of sports. He played two decades for the same team with class and humility, was a great teammate and leader, and a wonderful role model.Bill Gross is also a rare breed, as evidenced by his market-beating returns and enormous success. However Mr. Gross was also known to be extremely demanding and difficult to work with; even he would likely admit he could have been a better teammate and leader. But he remains a thought leader in the investment community and will always be known as the founder of one of the world's formidable investment firms. Highly accomplished people are often difficult to work with, particularly in high-stress professions where the stakes are high or large sums of money are involved. This is true in business, politics, the entertainment industry, and the military.

I have worked for and managed money for some of the most accomplished and demanding individuals in the investment business during my career. I learned early on that this is not a business for sensitive types. But I also know that I have been taught by the best and wouldn't have had it any other way. Managing money is a tough business. Managing hundreds of billions of dollars places an unimaginable burden on a person. Before people pile on Mr. Gross, let them walk a mile in his shoes. Nobody worked harder to deliver great returns for his investors over the last four decades.But eventually the stress and strain takes its toll, and the demands can become unmanageable...

Gross' "Minsky Moment"

There is no doubt that Mr. Gross also truly is in a class by himself as an investor. He created total return fixed income investing in the 1970s and managed more money than any individual in the history of the world for over four decades. And despite recent setbacks (which in the scheme of things are truly minor), he continues to claim one of the best track records in the history of investing. Over the last 15 years ending August 31, 2014, his PIMCO Total Return Fund (MUTF: PTTRX) earned an annualized return of 6.9%, beating 96% of its peers. Since its inception in May 1987, PTTRX has earned an average return of 7.9% while the Barclays U.S. Aggregate Bond Index averaged 6.8% annually over the same period. In 2008, when many investors got their clocks cleaned, PTTRX produced a positive return of +4.8% and beat most of its peers, a performance of which few investors in any asset class can boast. PTTRX generated that return while maneuvering an enormous sum of money, which makes the feat even more remarkable. Mr. Gross himself acknowledged that over the course of his career he benefitted from investing during the epic bull market in bonds that began during the years when Paul Volcker ran the Federal Reserve and tamed inflation. But his outperformance illustrates that he did much more than benefit. Now that this bull market has ended, he has the opportunity to bring his unparalleled expertise to bear on a more challenging environment. I wouldn't bet against him.While praising Mr. Gross for his past accomplishments, it is also fair to suggest that he began to stretch for returns in recent months as he struggled to navigate the Battleship PTTRX through the shoals of increasingly unforgiving fixed income markets... When the returns of PTTRX began to lag in 2013, he engaged in a series of moves to improve performance that failed to work. Very recently, he extended the duration of the PTTAX portfolio from 5.0 to 5.7 years, sold most of his Treasuries and replaced them with derivatives (Treasury futures), introducing more counterparty risk into the portfolio, and began buying peripheral European sovereign debt. As of September 15, the fund was trailing 2/3 of its peers and had earned 1.6% year-to-date. Mr. Gross's recent strategy was driven by PIMCO's thesis that the economy is entering a period it describes as the "new neutral" which will be characterized by below-trend growth and slower-than-expected interest rate increases. While I concur with this thesis, I disagree that the right response is to increase leverage (through derivatives or otherwise) and wade into riskier debt such as European peripherals trading at unsustainably low yields.

Mr. Gross's recent moves are the type of behavior that the great economist Hyman Minsky warned about when he developed his "financial instability hypothesis" that argues that stability breeds instability. As investors spend more time in a stable market environment of the type that has persisted over the past few years, they tend to take more risk. This appears to be precisely what Mr. Gross was doing prior to his departure. Mr. Gross's former colleague, Paul McCulley, coined the term "Minsky moment" to describe what occurred in the 2008 financial crisis when stability tipped over into instability. Perhaps someone should hand out a copy of Professor Minsky's famous essay at the next meeting of PIMCO's credit committee. With global debt reaching ever more epic levels, this is precisely the time investors should be reducing rather than increasing risk. With Gross' departure comes risk, one that we may not want to take, and we need to think in terms of what's in store for PIMCO in the near future....

The Near Future for PIMCO

Investors are asking what they should do with their investments in PIMCO-managed funds and ETFs. There is no question that Mr. Gross's departure was handled poorly both by him and the company. Investors were caught flat-footed at the abrupt resignation of the manager of the world's largest bond fund - and that is inexcusable. Reports that he was about to be summarily fired and resigned in order to avoid such an ignominious end suggest that management at the firm failed. Such failure is particularly inexcusable in view of PIMCO's size and systemic market importance. PIMCO retains a strong group of investment professionals, but institutions and wealth managers are fiduciaries with a low tolerance for serious management lapses. Accordingly, and as we might expect, PIMCO is already seeing large outflows from its funds and ETFs that may accelerate over time as clients come to realize just how poorly PIMCO managed this situation. The question for investors is less about the firm's expertise in managing money, which should not be questioned, but about whether its mishandling of the management transition was serious enough to lead one to want to move elsewhere. PIMCO remains a formidable firm... But it has some damage control ahead of it in the short-term.

Wall Street sees 'danger signs' of a sell-off as bonds soar, flaws in trading system emerge

By Bernard Condon, AP Business

Wed, Oct 1, 2014, 2:57pm EDT

In this Sept. 24, 2014 photo, traders work in the ten-year bond pit on the floor of the CME Group in Chicago. Main Street investors have poured a trillion dollars into bonds since the financial crisis, and helped send prices soaring. As fund managers and regulators fret about an inevitable sell-off, the bigger fear is that when people go to unload, there won’t be anyone to buy. (AP Photo/M. Spencer Green)

NEW YORK (AP) -- A bottleneck is building in the global market for bonds.Main Street investors have poured a trillion dollars into bonds since the financial crisis, and helped send prices soaring. As fund managers and regulators fret about an inevitable sell-off, the bigger fear is that when people go to unload, there won't be anyone to buy.Too many funds own the same bonds, making them difficult to sell if panic ensues. On top of that, the banks that used to bring bond buyers and sellers together have pulled back from the role. If investors started looking to sell, they'd be slow to find buyers, spreading fear through the $100 trillion global bond market and sending prices tumbling.It's a situation known as "liquidity risk" and some bond pros are scrambling to prepare for it.Worried portfolio managers are hoarding cash. BlackRock, the world's largest fund manager, is suggesting regulators consider new fees for investors pulling out of funds. Apollo Management, famous for profiting from a bond collapse 25 years ago, is launching a fund to bet against bonds.

What's at risk is more than money in retirement accounts. Big investors often borrow when buying bonds and so losses can be magnified. Trillions of dollars of bets using derivatives ride on bonds, too.

A small fall in prices could lead to losses that reverberate throughout the financial system."There's no place to hide," says JPMorgan's William Eigen, head of the Strategic Income Opportunities fund, who has 63 percent of his portfolio in cash.Here are the reasons bond experts are worried:

HIGH PRICES: Demand and prices have soared for nearly every kind of bond, even the diciest. Since the start of 2009, funds invested in "junk" bonds from risky companies have returned an average 14 percent each year, double its average in the prior six years.

RISE OF QUICK-HIT INVESTORS: The biggest owners in many bonds are small Main Street investors more easily spooked than traditional holders like insurers and pension funds. Main Street investors buying through mutual funds and exchange traded funds, vehicles for quick-trading, own 40 percent of corporate bonds, according to the International Monetary Fund. The insurers and pension funds that help stabilize the market by sticking with bonds through busts hold 25 percent.RATE HIKES: This market faces a big test next year when the Federal Reserve is expected to start raising interest rates. When the Fed announced a series of surprise rate hikes in 1994, bond prices plunged, a big hedge fund collapsed, companies like Procter & Gamble were hit with losses and Orange County, California, had to file for bankruptcy.Many people don't think the rate increases next year will roil the bond market much because the Fed is telegraphing its every move. But given the high prices and lack of liquidity, not everyone is confident."The market isn't pricing in the risk that it's going to be like 1994 — or even worse," says Hans Mikkelsen, global credit strategist at Bank of America Merrill Lynch. His worries were echoed recently in an IMF report warning that a breakdown in trading could lead to "fire sales" in some parts of the bond market.TRADING PROBLEM: To buy or sell many kinds of bonds, you have to phone or email brokers at banks and other firms who pair buyers and sellers. If they can't find a match for you, they dip into their own stash of bonds to buy and sell themselves.But banks and other middlemen are pulling back from this matchmaking because of new regulations limiting their activities. And they have largely abandoned their role as a buyer or seller of last resort. They've slashed their stash of bonds by 80 percent since 2007, according to State Street Global Advisors.The result is a shallow market in which buyers and sellers struggle to find each other, and prices can fall fast.After the Federal Reserve hinted at a pullback from its bond-buying program last year, bonds from the safest "investment grade" companies fell 6.2 percent in less than two months, according to Barclays Capital.

Bonds bounced back when the Fed delayed its withdrawal of stimulus, but it spooked fund managers. They responded by raising cash from 6.3 percent before last year's sell off in May to 9 percent a year later, according to the Investment Company Institute.

That extra cash helped when junk bonds fell recently. Fearing the Fed might raise rates faster than expected, investors pulled billions of dollars out of junk bond funds earlier this summer. Many fund managers were able to the pay the investors without causing a panic. By the end of the month, the funds had fallen an average of 1.2 percent, according to Morningstar.

"Everyone thought it would be a blood bath," says Marilyn Cohen, founder of Envision Capital, a bond manager. The story is "crisis averted, for now."

But Michael Lewitt of the Credit Strategist Group is warning investors not to fool themselves that the worst in over. "When there's little liquidity, it doesn't take many sales to move the price," he says.

October 1, 2014Many experts claim we're not in a bubble economy because they can't see the "bubble." Why is beyond me. The bubble is so enormous that any serious bailout attempt would have to encompass the entire shootin' match, or roughly $600 trillion to $1.5 quadrillion ($1,500,000,000,000,000) in order for it to work. That's the total estimated amount of outstanding derivatives, credit default swaps, and exotics outstanding according to various industry sources. I say estimated because nobody actually knows for sure, as the derivatives markets remain almost entirely unregulated. And, that's why the well-intentioned but completely misguided onesey-twosey's bailouts and Band-Aids we've seen so far won't cut it despite the fact that they're already into the trillions of dollars. I say this because, despite what most politicians and central bankers think, we are not staring at a series of independent bubbles blown into the wind, but a single, massive all-encompassing monster bubble that surrounds us all.But don't abandon the ship yet. We can get through and take our profits at the appropriate time; all it takes is a little moxie and a steady game plan like this one...

How We Got Here Is a Story in Itself

The total value of the United States' economy is approximately $16.9 trillion. The world's GDP is around $73.8 trillion, while the total capitalization of world stock and bond markets is approximately $212 trillion depending on various sources. You can see the problem represented at left as easily as I can... there literally isn't enough money on the planet to bail us out, and I don't care who's got the keys to the printing presses.

Bubbles this big don't form overnight. What we've been handed is an overlapping bubble that's gotten progressively larger over time as our legislators, bankers and regulators have progressively "improved" the system. Following World War II, we levered up approximately 10 to 1 as the United States, Europe, and Japan recovered. Then, in the 1970s, the United States moved away from the gold standard. Other nations followed, taking global leverage higher; 30 to 1 became the new standard. Following the Asian currency crisis and the beginning of Japan's Lost Decade, things jumped to 60 to 1 as ChinIndia, the Dot.bomb boom, and housing took off. In 1999 Congress tore down Glass-Steagall with the Gramm-Leach-Bliley Act, and in the process removed many of the limits between commercial banking and securities firm affiliations. Shortly thereafter, it passed the Commodity Futures Modernization Act in 2000 which specifically exempted credit default swaps and other exotic derivatives from reporting. That created a Wild West-like atmosphere for traders and their firms using leverage that jumped as high as 100 to 1. The bubble simply grew and grew... and grew. And it's not just in one market either... but in every market. I believe this is precisely what our leaders and bankers are missing. To them, the crisis appears like a bunch of independent bubbles each with its own unique set of causal factors and solutions. Take your pick: the housing bubble, the credit bubble, the EU, China - you name it, only they're not so independent.

The Problem with the "Smartest Guys in the Room"

So why do guys like Ben Bernanke, Paul Krugman, Janet Yellen, our Congress, the ECB, the Bank of Japan, and China's Central Bank like the idea of printing their way out of this mess? Three reasons:

They want to get reelected and/or maintain their own power base in a dramatic demonstration of Parkinson's Law;

They have failed to understand the lessons from Japan's experience (and 2,000 years of recorded monetary history before that);

They cannot comprehend that this crisis was caused by too much money rather than too little so they won't admit what they are doing isn't working and pursue another course of action.

I've commented extensively since this crisis began about what they should be doing, so I'm not going to delve into those details again but here's a quick summary:

Force banks to decide... either they are commercial or investment banks. No in-betweens, no hybrids, and no accounting gimmicks. Break up those who will not cooperate by legislative force if we have to. No taxpayer should be liable for their transgressions. Period.

Reinstate Glass-Steagall or some variation of it. Dodd-Frankenstein won't work. The system is broken so scrap it and begin anew.

Let failure happen. History is littered with the bones of failed financial institutions. Things may change, but finance is a process of evolution and it always has been. The key is not allowing mutants to have their run of the planet when what the public trust requires is security, integrity, and honesty.

No netting. Enact global standards that require big banks to report the true value of their exposure. People were upset about JPMorgan's losses and had a hard time understanding how the bank's trading losses ballooned from an initial $2.1 billion figure to $6.2 billion... until they comprehended that Bruno Iksil, (a.k.a. the "London whale") may have had total exposure exceeding $130 billion, according to industry insiders familiar with the trade.

Let the markets decide how much is too much. Don't use policy instruments to play God. Some sources suggest that big banks still hold hundreds of billions in trading assets that remain exposed to comparatively illiquid asset markets. Assuming the world's big banks remain levered in line with historic capital ratios, a 20% correction in global markets could wipe them out. With taxpayers still now on the hook for some of that downside risk with the Fed, which is functionally insolvent, that's hardly an appealing thought.

You may have your own opinions or even disagree with mine. That's okay and expected. There are no easy solutions this time, nor is there a singular perspective.

But there is a way to profit amid the turmoil...

How to Beat the Bubble Economy

In terms of what we do as investors, there are certainly easy choices. First, the return of your money has to be more important than the return on your money. Period. Any investment you make has to be made with the concept of safety in mind and the preservation of value at hand. To me this means shifting focus from what the world wants to what the world needs, particularly when it comes to energy, inflation-resistant choices, and dividend-producing stocks with high free cash flow. Second, don't walk but run away from long-term bonds and fixed-rate investments. I know this will piss a bunch of people off, but that includes many annuities and whole life insurance holders. Any rise in interest rates, and we know they are coming, will crater the value of these instruments and subject your wealth to unnecessary volatility.

Short-term bonds and variable-rate instruments are a different story. There you have at least a limited capacity to absorb the changes that will come from rising interest rates and a changing global financial system by continually recycling into new, higher rate instruments as they become available. Third, make sure you are equipped to "buy and manage." Buy and hold has been dead for years and is unlikely to ever return. Sadly most people don't realize this and continue to confuse it with buy and "hope." A lot of people don't like them, but I am a big fan of trailing stops. I encourage any investor who's serious about their money to use them as a means of capturing profits and protecting their hard-saved capital from serious market hiccups. Put options are a good choice for those with a more sophisticated toolset. And fourth, you've got to know when to step back in. I know that sounds like a contradiction given the stage I've just set in this article, but knowing when to buy is critical in markets like those we're living through now. Don't confuse this with market timing. What I am suggesting is that the markets have an upward bias over time, therefore outstanding performance over time becomes a matter of identifying relative weakness and buying into it rather than running the other way. So don't give up the ghost. Understanding the big picture as I have laid it out will help you comprehend the world we live in and how to use the mistakes policymakers are making to your advantage. It may not be easy to deal with emotionally, nor pleasant to think about. But that doesn't make it any less important. Believe it or not, the global financial crisis is actually helping us approach a point where market conditions will again favor buying more than selling, and even our policymakers won't be able to screw that up. Any correction we have now simply means there's more buyers for the next rally ahead.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.